How China Sunergy's Strategic Shift Will Affect Forward Earnings

| About: China Sunergy (CSUN)

China Sunergy (NASDAQ:CSUN) reported strong earnings when it reported its Q3 2010 earnings last quarter. Revenues grew 7% sequentially to $125.8m on higher average selling prices, as total shipments remained flat quarter over quarter. Net income totaled $15.4m, an increase over the $13.8m recorded in the second quarter. Earnings per share for CSUN’s third quarter were $0.37 vs. Wall Street consensus of just $0.23, and well ahead of my estimates of $12.5m in net income.

As noted in my prior analysis, CSUN remained capacity-constrained due to its conservative expansion strategy in the year prior. Had the company increased capacity, it probably could have shipped higher volumes, as the entire industry remained in a sold-out state. Nevertheless, the company was still able to generate a high level of quarterly earnings per share relative to its $4.50 share price. Beyond its absolute level of earnings, the company took a series of initiatives which could dramatically alter its operating structure moving forward.

For all of China Sunergy’s operating history -- from its U.S. IPO in 2007 to its Q3 2010 earnings report -- the company operated as a single vertical solar cell manufacturer with metrics entirely reliant on spot market pricing. Its key raw material, silicon wafers, was procured almost entirely on spot pricing or contracted pricing fixed at ratios to spot levels. Silicon wafers, which have historically ranged from 75-90% of its cell production unit cost, remain one key factor in determining profitability levels. The other major contributing metric is the average selling price for its solar cells, which also correlates to spot market dynamics.

As a result, the profitability of the company is linked to the spread between these two spot market variables, wafer and cell pricing. This spread has historically not been very large for CSUN. In fact, China Sunergy lost money in each of the three fiscal years prior to 2010, even as other solar peers were able to generate profits.

Last year, however, fortunes for the company turned as the entire industry experienced roughly double the demand seen in the year prior. Although pricing at both ends of CSUN’s spectrum had seen increases, the spread was healthy enough for the company to generate extremely good earnings. For the first three quarters of 2010, China Sunergy generated $36.3m in net income, or $0.88 in EPS. This compares to $38.3m in losses the company compiled in the prior three fiscal years combined. If CSUN’s Q4 2010 earnings come in as expected, the company is set to report over a dollar in EPS for fiscal year 2010.

Moving forward, CSUN first took action to vertically integrate into a two-vertical cell and module producer by acquiring its sister companies CEEG Nanjing and CEEG Shanghai. Although there were some delays, the acquisition was completed last November for a total purchase price of $46m. Since both sister companies are controlled by the same chairman as CSUN, and since nearly three quarters of the company’s sales were related to CEEG in the third quarter of 2010, the purchase itself does little to change the company’s business or industry position. Had they remained separate entities, China Sunergy’s fortunes would have remained tied to CEEG’s ability to sell their modules using CSUN’s cells, given an increasing proportion of its business became linked to CEEG. Merging the three companies, however, should significantly affect the way CSUN reports earnings as a U.S.-listed public company.

First, adding another vertical should incrementally add to the per-watt gross margins the company can attain per level of shipment. In recent quarters, due to strong demand, the cell vertical has been able to generate around 0.25-0.30/watt in gross profits, while the module vertical garnered about 0.10-0.15/watt. Thus, by adding CEEG’s module capacity of 480mw, CSUN could incrementally generate an extra 0.10-0.15/watt in gross profit per watt-unit shipped, assuming market dynamics remained constant.

Some of the extra gross profits would be offset by higher operating costs, but the overall result should generate additional operating income. Although the profitability levels for each vertical can change dramatically, depending on business conditions, increasing the spread between procurement costs and selling prices through an additional vertical should help buffer the company’s performance in the event that business conditions become more challenging.

More recently, China Sunergy announced a very large wafer contract with GCL Poly, the largest polysilicon and wafer producer in China. GCL has also been regarded as a low-cost provider for its customers, often selling at 10% or greater discounts to spot market prices.

For example, CSUN noted its blended wafer costs for Q3 2010 was $0.88/watt. This implies its wafer purchases during the quarter were at even higher levels since its wafer costs were $0.83/watt at the end of the second quarter. However, GCL averaged just $0.80/watt on wafer sales in the same period. Other large GCL customers have also hinted at similar discount rates.

The size of CSUN’s GCL contract averages out to be slightly above 700mw per year for six years. It’s likely much of the volume is backend-weighted, but even half that average would have dramatic effects on CSUN’s blended wafer costs this year, assuming it was also given similar preferential pricing. What this supply contract could do for the first time in China Sunergy’s operating history as a public company is remove its exposure to spot market wafer procurement. With less exposure to spot market forces, the company’s blended wafer cost should average at lower levels moving forward. Having the lowest unit costs possible becomes increasingly important if market conditions become more challenging and the spread between vertical pricing compressed.

Since December of last year and so far this year, the market dynamics for the solar industry have increasingly become more challenging. Spot pricing at the cell level has dropped below $1.20/watt only to stabilize around that area recently. Wafer spot market pricing has also come down, but to a lower degree at roughly $0.91/watt recently, down from about $1.00/watt last quarter. As a result, CSUN’s spread between its cost and sales verticals at spot market pricing had shrunk from $0.50-0.55/watt to $0.25-0.30/watt. Factoring the company’s processing costs into account, the compression becomes even more dramatic as per-watt gross margins at the cell level dropped from around $0.30/watt to $0.05-0.10/watt.

Luckily for China Sunergy, the integration of its module verticals should be complete by the first quarter of this year. As detailed above, increased integration should improve per-watt gross margins, but there could still be risk for severe per-watt gross margin contraction if CSUN remains exposed to the spot market. With spot market module pricing around $1.60/watt recently, the spot market spreads would only grant CSUN around $0.15/watt in gross profits, or about half the levels it enjoyed in the third quarter of 2010. On a percentage basis, its gross margins could shrink to the low teens percentile or even around 10% in the first quarter of this year, from the 19.9% it recorded in Q3 2010 and from the 15-16.5% it guided for the fourth quarter.

In the company’s third quarter conference call last year, CSUN did offer some guidance on its expected module average selling prices for the first quarter of this year. Based on its guidance, it expects module asps to be around $1.75/watt or slightly higher in Q1 2011. If this pricing level holds, then the company should still be able to maintain stable per-watt gross margins relative to Q3/Q4 2010 levels and report gross margins in the high teens percentage. It is important to keep in mind CSUN’s Q3 2010 conference call came before dramatic and unexpected spot market pricing declines, which started in December of last year.

As the company moves forward into 2011, if it can improve its wafer procurement costs either by receiving higher volumes of preferentially-priced wafers from GCL or through similar avenues, then it would have a higher chance to maintain more stable gross margin. To date, the only source of certainty China Sunergy has is its contract with GCL, so volume as well as pricing will be critical for its profitability level this year. Without high enough volume or low enough contract pricing, CSUN would continue to remained exposed to spot market dynamics, which have turned very unfavorable in recent months.

For the fourth quarter of 2010, however, business dynamics for CSUN were still very favorable. Despite a dramatic 12-15% wafer cost rise as guided by the company, average selling prices for cells should also tick up to compensate. The company also guided for 58-63mw of module shipments due to integration of its CEEG acquisition, up from 3.4mw of module shipments in the prior quarter. Although increased module shipment dilutes gross margin in terms of percentages, it adds incremental gross margins on a per-watt basis, which should help profitability levels remain stable relative to the prior quarter. As a result, China Sunergy should see a dramatic sequential rise in revenues, coupled with a moderate rise in gross profits. Absolute levels of net income should also increase slightly, compared to the prior quarter.

Revenues: $188m
Shipments: 45mw cell @ $1.45/watt, 63mw module @ $1.95/watt
Unit Costs: 45 x 1.22 = 54.9m + 45 x 1.57 = 70.7m + 18 x 1.80 = $32.4
Gross Profit: $188m - (54.9m + 70.7m + 32.4m) = $30m
Gross Margin: 30m / 188m = 16%
Operating Costs: $9m
Net Interest Expense: $2m
Tax: $3m
Net Income: $16m
Diluted Share Count: $40m
EPS: $0.40

As a final note, the estimates above exclude foreign exchange translations. With key exchange rates only 2% off prior quarterly levels, combined with CSUN being hedged to an extent, should yield minor overall currency effects. It’s possible with higher levels of module shipments to EU countries that the company could post a small forex loss in the magnitude of $1-3m as the euro lost roughly 2% vs. the USD in the fourth quarter.

In addition, the company still has an unresolved legal matter with REC involving a $50m prepayment amount. Resolution could come at any time, as another court hearing is scheduled for March of 2011. How this dispute gets resolved could have a dramatic impact on CSUN’s financials, since $50m could impact the company’s earnings by 1.25 in EPS if it has to write off the full amount as a charge.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.